PTET refund roadmap — Expert insights with Dave Kirk

On this episode of the Tax Section Odyssey podcast episode, Dave Kirk, National Tax Partner — EY, and Chair of the AICPA’s Pass-through Entity Tax Task Force, discusses the complexities surrounding state tax refunds related to the pass-through entity tax (PTET) and delves into the challenges posed by the lack of IRS guidance, the application of the tax benefit rule and varying state regulations. Dave emphasizes the importance of consistency in handling these refunds and advises practitioners to involve taxpayers in decision-making due to the inherent uncertainties and risks.

 

AICPA resources

 

FAQ on the Federal Taxation of State Income Tax Refunds for PTET Payments — FAQ guidance on the federal taxation of state income tax refunds for PTET payments.

AICPA list of taxpayer and practitioner considerations for whether to elect into a state pass-through entity (PTE) tax — Various issues should be considered when deciding whether a taxpayer can, and should, elect into a state PTE tax.

Pass-through Entity (PTE) Taxes States’ Legislation and Tax Authorities’ Information and Guidance — A state-by-state PTE matrix tracking and linking to legislative updates, guidance, as well as other relevant information.

State and Local Tax (SALT) Roadmap and Resource Center — Browse the reference library for the latest guidance and tools to address your state and local tax needs including tax rates, due dates, nexus, PTE tax and more.

Transcript

April Walker: On today's podcast, listen to learn more about how to handle refunds related to the pass-through entity tax.

Hello everyone and welcome to the AICPA's Tax Section Odyssey podcast, where we offer thought leadership on all things tax facing the profession. I'm April Walker, a Lead Manager from the Tax Section and I'm here today with a repeat guest, Dave Kirk. Dave's with National Tax at EY. He is the knower of a lot of things, but specifically today we're going to talk about PTET.

Dave, let's start off with, I think when we chatted before, we talked about pass-through entity tax fun with that, we're delving into a very specific issue related to it. Let's first talk about the challenges. There are so many challenges around this, the lack of guidance around PTET, but today we're going to talk about refunds and there isn't guidance really. How has that impacted our practitioners?

Dave Kirk: First of all, thanks for having me again. Being the leader of the PTET Task Force for the AICPA and having to deal with this for E&Y nationally, I've probably spent 500 hours of my life on this that I'm not getting back. It's just that each state is different. You could probably group states together. It usually requires a case-by-case analysis on how the deduction was taken, when the deduction was taken, and how much money the taxpayer is getting back.

The [IRS] Notice 2020-75 only talked about taking the deduction. There was not one word in that notice talking about refunds. You're right, April, there is no formal guidance from the IRS on PTET refunds. But this is also not the first time in US history where a state government has given money back to a taxpayer. Our federal tax system, as we currently know, it has only been around for 110 years or so. We do have guidance scattered throughout that last century of payments of taxes, deductions for taxes and recoveries. You might call it the common law of refunds that we would use in the absence of anything specific coming out of the government on how to deal with this.

Walker: Tax benefit rule, right? It's been around for a little bit.

Kirk: Yeah. There's two aspects of the tax benefit rule. There's the exclusionary aspect of it, and that's been codified about 40 years ago into Sec. 111 of the code. Then there's also the inclusionary aspect which kind of says, hey, you got a benefit for a payment back in a prior year and you have got that payment returned. That should be something, that should be Sec. 61, gross income. But where the complexity arises is, first of all, you can tell whether something is taxable or not taxable based on whether you got a benefit for it in a prior year.

Okay, great. That's relatively straightforward, and I say relative with some emphasis there. But then you'd go down a very slippery slope really quick once you do determine that a PTET refund is taxable, because then you have to ask yourself, what characteristics does that taxable refund have? That is a morass that I don't think that the government ever really envisioned. I'm not envisioning any sort of guidance coming out of the government within the next 12 months on this.

Walker: The last count, we have 50 states. Like you said, you can group them maybe, but each state was allowed with the IRS notice to develop their own regime which causes all kinds of fun. Which again, we won't get into specifically today.

But like you said, it seems like we could the tax benefit rule and thoughts around that, or how we are going to try to provide some assistance to you with a resource that's been developed. You mentioned that you are the Chair of the AICPA Task Force for PTET. We thank you so much for all the things you do for the AICPA. In doing that, you guys have developed some really helpful FAQs around different nuances, some examples or some summary activities that can happen. Let's provide our listeners with some of the key takeaways from those FAQs.

Kirk: First, states matter, and who's getting the refund matters. If you're an S corp and let's just keep this simple that you have at dentist that owns an S corp. That S corp makes $1 million and it owes PTET at the S corp level of say, $80,000. What you do assuming cash basis and assuming you pay the exact amount of PTET on December 31st, that you can deduct it. Your K-1 line 1 should be $920,000. You are going to get a credit on your local state return of $80,000. In a vacuum, you should not have a state liability equal to or greater than or less than the $80,000. In a perfect world, that's how the system works, and that's probably about as complicated as the system was ever supposed to be in the eyes of the IRS.

But you know that no one ever hits their tax liability at 100 percent. You might hit by 99, 98% or 101 or 102%, but you're never exactly on the dollar. First is the S-corp. If you thought that you owed $80,000 and you made that payment in December of 2023. Cash basis taxpayer, you reduced your K1 income by the $80,000. But when you get around to filing your return and you only owe $79,000, when the S-corp files the PTET return, the S-corp is overpaid $1,000. That should be income back to the S-corp because in 2023 they deducted 80,000.

They only should have deducted 79k and so they get it back. In a vacuum, next year, I'm going to have $1,000 of income on my K1 that I wouldn't have otherwise had if I wasn't in this PTE regime. Simple. Now if I deducted it on the front page of the return because I'm just offsetting my dental practice income or whatever it is, that PTET payment is no different than rents or salaries or insurance or whatever it is. Ok fine. So when I pick it up, that $1,000 refund in the next year, that should also be similar to my dental practice income, it's simply reversing a deduction.

If that amount is, if I say for example, reduced passive income, maybe I'm a part owner of a dental practice that I don't practice anymore and I'm passive. Then that should come through as passive income to me because last year the deduction was probably a passive deduction. Or if I was in a business that generates QBI, qualified business income, under 199A and I deducted PTET against it last year. If it reverses, then it feels like the right answer should be it's 199A income, good QBI when I pick up my refund.

But that is where the inclusionary aspect of the common law tax benefit rule would come into play. You think about it in the same way of self-employment income. Is if a partnership that you were in your subject to self-employment income on the Line 1 and your PTET deduction reduced Line 1, and that amount is refunded to the partnership, or some portion of that was refunded back to the partnership in year 2, that should probably be self-employment income. Just because the deduction reduces self-employment, you'd think that the income should increase self-employment. That's at the entity level.

But then you have to think, going back to my original example, my dental practice made a million dollars and paid $80,000 of PTET. I turn around and I file my personal return and because of credits or dependent exemptions or whatever it is, I owe only $76,000 on my 1040, on state version of my 1040. I'm going to get $4,000 back from the state. Then the question is, what is that? I first start with the concept of I have $4,000 and so Section 61 says that's income, I'll live with that.

Then I go to Sec. 111 and said, do I have a benefit from a prior year or do I not? If I don't have a benefit in a prior year, then this income shouldn't be income so it would probably be excluded by [Sec.] 111. But because they took the $4,000 of a deduction on the front page of the 1120-S, it reduced my K1 number. I did get a benefit even if I had an NOL that I could use and I didn't pay any tax on a prior year. It just means I used less NOL. Or that if it was passive income and I had passive losses that would be able to offset, but it would still be income to me.I still got a benefit even though I had other personal attributes that minimized that income, it would still be income.

It's much harder though, to think about, look, I am getting this refund and should a state refund be QBI? Because it came from the state, it didn't come from the entity like in the first part of our discussion, should it be self-employment income? That's never been the case before that a state tax refund is self-employment income. That's just weird because itemized deductions for state taxes were never self-employment because you'd never got to deduct them from self-employment. You have all of these character questions.

But that is simple when you're looking at the individual and the entity in a vacuum, and that's where we started that I'm a dentist, I own 100 percent of an S-corp and that's all I have. But as soon as I start injecting other things such as a spouse with W2 withholding or estimated payments that are made at my 1040 level or composite returns that I'm filing in other states and getting out-of-state tax credits on my local return. That gives rise to the question of if I get money back from the state, is it really the PTE credit that I am getting back or am I getting back my estimated payments? Or am I getting back my W-2 withholding or my spouse's W-2 withholding? That part, what is it, is a question that we've never really had to wrestle with in the last 100 years because taxes were always deductible in prior years, prior to TCJA.

Yes, we had the AMT system and everyone knew how to do that calculation of how much of the taxes puts you in an AMT and did you even get a benefit at all? But the composite taxes, the withholding taxes, estimated payments, they were all treated the same. But now you have this special class of tax credit, deemed tax payment, whatever you want to call it, that, is almost like a hydra with multiple heads of, what is it?

In the FAQs, basically say, "Look, we think that absent any guidance specifying that certain items come first, that you pick a method and you stick with it year over year." A duty of consistency. If you want to take the position that every dollar of refund first comes from estimates and withholdings. Basically your Schedule A, taxes that are capped at 10K. Then chances are those coming back to you will not be taxable because you capped out at the 10K and you never got a benefit under the tax benefit rule. Another alternative is to say that the PTE credit comes back first, but that would almost certainly be taxable if it was deducted on Schedule E or are embedded in Line 1 of a K-1. That's probably not very common for people to take that position.

But the other one would be, look, if you have $80,000 of PTET credit and you have 20,000 of withholding than $0.80 of every dollar coming back could be taxable and 20% would be associated with the withholdings or whatnot. Maybe that would not be taxable. That would be like a pro rata method. But absent guidance, it's Choose Your Own Adventure. Just don't get eaten by the dragon at the end.

But that's what we're instructing our folks inside of E&Y is to just be consistent and let the taxpayer in on the discussion. Don't make unilateral decisions on their behalf. And let them know that there is uncertainty, there is risk, and that the IRS may disagree on taking estimates first and whatnot. That they should to the extent that they are running into this problem. That if I know that my PTET is being overpaid at my partnership or S corporation level, then I should take corrective measure at my personal level either, by reducing estimates or trying to ratchet down withholding of my spouse on her W2 or his W2 to try to make sure that you're not overpaying too much because you're still giving interest-free loans to your state and local governments and that still doesn't make any sense.

Walker: That's a great summary of what's included and the different situations that we go through [in the FAQs]. But consistency, I think, is a good rule. Also, if we note the fact that the IRS hasn't and likely will not put out any guidance on this. I think it's really interesting that here we are in the middle of 2024 and TCJA is scheduled to sunset at the end of 2025 and we're dealing with this. It may become a moot point, but it's still very important that people are just really wrestling with this very complex issue and without guidance, it's hard to make a plan.

Kirk: I think the IRS is keeping their fingers crossed, that the SALT cap expires and the TCJA and PTE regimes will just expire and everyone will go back to itemized deductions. I'm not sure that's in the cards, because even if the SALT cap goes away and that itemized deductions are fully allowed for taxes, just like was in pre-TCJA land. The PTET regime is still beneficial from an AMT perspective. I wouldn't be the least bit surprised that you're going to have maybe state societies and taxpayers and the likes start lobbying their state governments in the next year to extend the PTE regime past 2025, make it permanent.

Because of the AMT benefit, regardless of what happens in Congress on the cap. Whether cap goes away, cap goes up, cap stays where it is, whatever. Because the people on the coasts, the high-net-worth individuals on the coast and in the highest tax states, California, Oregon, New York, New Jersey, Connecticut, Massachusetts. You all know where you are, Illinois, whatever, that taxes and 2% miscellaneous were the ones that put you in AMT to start with. The fact that you could get their local governments to go along with this, I don't think that this topic is going away for taxpayers or the IRS. I think that both sides, both taxpayers and the IRS need to I would say wake up to this. This is something that's in my mind here to stay for the long term.

Walker: I don't know if that's good news or bad news. I'm not sure how I feel about that. It is news. That's what we're here, is to let people know. Here's something you need to not bury your head in the sand about. Any other final thoughts as we're wrapping up? Dave, any advice?

Kirk: Advice is that it is a lot more complicated than people appreciate. That I know I've heard certain preparers, usually it's smaller firms, really small. Just say that this stuff it's not taxable if the state doesn't give you a 1099-G. The 1099-G has nothing to do with whether something is taxable or not. The taxability of something landing in a checking account, direct deposit, or via check. The default position is it's taxable unless you can tell me why it's not. That's always been the case in the code. I think that's the way people need to approach it. Start with taxable and let's figure out a way for it not to be.

Walker: Great. That's good final advice for everyone. Dave, in closing on these podcasts you've been with me before, but I like to think about us taking a journey. We're the Tax Section Odyssey, we're taking a journey toward a better profession. But I also like to hear about my guest other journeys outside of the world of tax. I do have some insider information — I know you were just on a trip, do you want to share something about that. How did that go?

Kirk: We just got back a couple of days back from 16 days in Alaska. We flew into Fairbanks, took the train down to Denali and then carried on down to Anchorage, and then got on a ship and made it all the way down to Vancouver.

Walker: Nice.

Kirk: I expected a lot of strange things to happen, maybe be chased by a moose or something like that. But what I didn't anticipate is when I took the train from Fairbanks down to Denali, that a spark shot off the train and started a forest fire at the entrance of Denali. Within two hours of us getting to the entrance to the park, the forest fire had spread to such a point where it burned all the power lines and the park had been is now I think just opening up after being closed for about two weeks. Ironically, I've been to the entrance point of Denali twice in my life and I've never actually been able to make it into the park. That gives me a reason for a third time to return to the interior of Alaska.

Walker: Yes. I like your positivity there, rather than taking it as maybe you don't need to go back to Alaska. I don't know. I hope you were able to experience some of the loveliness of Alaska even though you weren't able to get into Denali.

Kirk: Oh, it's beautiful. For those that like the outdoors. It truly is a magical place.

Walker: Wonderful. Thank you again so much, Dave. I hope this was helpful and good information for our listeners. It certainly was for me.

Kirk: Thank you for having me again, do it anytime.

Walker: Thanks. Again, this is April Walker from the AICPA Tax Section. This community is your go-to source for technical guidance and resources designed especially for CPA tax practitioners like you in mind. This is a podcast from AICPA and CIMA together as the Association of International Certified Professional Accountants. You can find us and listen wherever you find your podcasts and please follow us so you don't miss an episode. If you already follow us, thank you so much and please feel free to share with a like-minded friend. You can also find us at aicpa-cima.com/tax, and find our other Odyssey episodes, as well as getting access to the resources mentioned during this episode, specifically the FAQs that were the focus of our conversation today. Thank you for listening.

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